Foreign Currency

Transactions 10
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LEARNING OUTCOMES
After studying this chapter students should be able to:
 explain foreign currency translation principles;
 explain the correct treatment for foreign loans financing foreign equity investments.

10.1 Introduction
This chapter examines the provisions of IAS 21 dealing with the effects of foreign
exchange rates. Section 10.2 looks at the objectives of the standard and some of the prin-
cipal definitions it employs. Section 10.3 covers single transactions in foreign currencies.
The most complex section of the chapter, Section 10.4, examines the calculations required
to translate and then consolidate the financial statements of a foreign operation. Section 10.5
examines hedging of a foreign equity investment by a foreign loan.

10.2 IAS 21 The effects of changes in foreign

exchange rates
IAS 21 was revised and reissued in December 2003 as part of the IASB’s improvements
projects. It incorporates several important alterations and so those students who have
previously encountered foreign currency transactions regulated by the provisions of IAS 21
should study this chapter with care.

10.2.1 Foreign currency transactions: the accounting

problem
Businesses frequently conduct transactions and make investments using foreign currencies.
The accounting problem lies in the fact that the currency used in transactions is not the same
as the currency in which the business entity conducts its normal operations. Therefore,
in order to reflect the effect of the transactions in its own books and financial statements,
the entity must use a method of currency translation.
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A feature of foreign currency transactions is that they are subject to exchange risk, and
FOREIGN CURRENCY TRANSACTIONS that they may give rise to a loss (or, indeed, a profit) on translation.

10.2.2 IAS 21 Objectives and key definitions

The objective of IAS 21 is stated as follows:
The objective of this standard is to prescribe how to include foreign currency transactions and foreign oper-
ations in the financial statements of an entity, and how to translate financial statements into a presentation
currency.

Two distinct types of foreign activities are covered by the standard: first, single transactions
in foreign currencies, and second, foreign operations.
A foreign currency is a currency other than the functional currency of the entity.
A foreign operation is an entity that is a subsidiary, associate, joint venture or branch of a
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reporting entity, the activities of which are based or conducted in a country or currency
other than those of the reporting entity.
The standard identifies and defines two types of currency: functional currency and
presentation currency. Functional currency is the currency of the primary economic environ-
ment in which the entity operates. Presentation currency is the currency in which the financial
statements are presented.
As the distinction between the two implies, it is possible for an entity to report in a
presentation currency that is not its functional currency.

Functional currency
Where an entity operates in several different national environments it may not always be a
straightforward matter to determine its functional currency. Entities need to consider the
following issues in determining their functional currency:
● Which currency principally influences selling prices for goods and services?
● Which country’s competitive forces and regulations principally determine the selling
prices of the entity’s goods and services?
● In which currency are funds for financing activities (debt and equity instruments) generated?
● In which currency are receipts from operations generally kept?
● Which currency influences labour, material and other costs of providing goods or services?
Where consideration of the different factors does not result in a clear identification of the
functional currency, the issue becomes a matter of judgement for management.

Presentation currency
The functional currency of an entity is a matter of fact, although identifying it may not be
straightforward. By contrast, the entity’s presentational currency is a matter of choice. IAS 21
permits an entity to present its financial statements in any currency it chooses; this may dif-
fer from the entity’s functional currency. Why would an entity choose a presentation currency
that is different from its functional currency? One of the following reasons may apply:
The entity’s functional currency is relatively obscure. The entity may then choose to
●

report in a currency such as US dollars or Euros in order to make its financial statements
more transparent.
● The entity’s principal investors tend to function in another currency from the entity’s own

functional currency.
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2007.1
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